Using gold options to trade the debt ceiling

Gold rang in 2013 extending its impressive win streak rallying for the 12th consecutive year despite the last quarter of 2012 being the worst for the precious metal since 2008. With equity markets at multi-year highs and volatility at the lowest levels in the past five years, can we see gold extend its winning streak to lucky number 13? What is keeping gold from making new multi-year highs?

The uncertainty over whether or not the Fed will continue easing programs will likely put pressure on gold throughout 2013. QE3 is tied to economic data and we continue to see promising data month to month. Money printing could not shore up prices at the end of 2012 and an end to this program could send gold much lower. The strong equity market in 2013 also has pulled money out of the gold market as investors seek return from a stock market back at pre-crisis levels. Investors have become decidedly “risk-on” and safe haven plays like gold are losing their appeal. With stocks continuing to head higher and unemployment heading lower, could 2013 be the end of 12-year streak in gold? Not necessarily. There is still a catalyst looming over our heads that could send investors rushing back into gold, and it’s a big one, $16.4 trillion big. The debt ceiling.

Uncertainty over the debt ceiling has already helped the gold market get a bit of a bid with gold up almost 2% in the past month even as the stock market touches five-year highs. There has been a pullback in the past two days as the bill passed in the US House of Representatives could push the decision back to May, if the Senate and the President also approve the bill. If they don’t, Congress will have to vote on whether or not to raise the nation’s debt limit or face a lapse in obligations sometime in late February or mid-March. The spending cuts that were left out of the fiscal cliff deal are also set to kick in around the same time. Uncertainty around these issues could send investors rushing back into gold as the U.S. government sorts out its fiscal concerns.

Analysts at Goldman Sachs agree. In a report last week Goldman reiterated their three-month target for gold prices at $1,825 per ounce, almost 10% higher than current prices. They point to likely increases in uncertainty over the debt ceiling and increased central bank demand as factors that will drive the rally in gold markets. Central bank demand for gold is increasing the world over as concerns over the stability of the U.S. dollar and the euro increase. Central banks, namely The Peoples Central Bank of China, are likely to continue to increase their holds of bullion as they rotate out of foreign exchange reserves and into gold. Gold currently accounts for only 1.6% of China’s monetary reserves. Demand for gold by ETFs is also likely to increase as investor inflows into these funds continue to increase.

Even though Goldman report is bullish on gold over the next three months, the analysts see gold peaking in 2013 and have a long term price target of $1,200 by 2018. So how can an investor capitalize on this possible short term rally?

There are a few ways to do this:

Buy physical gold. Although this would offer the best exposure to the price of gold it is extremely capital intensive.

Buy the ETF. There are several ETF products to choose from that offer exposure to the spot price of gold and double and triple ETF’s can offer some leverage to investors. However, all ETF’s have expense rations built in so they can never track their underlying 100%.

Gold futures and options. Using gold futures and options offer the inherent leverage and capital efficiency that make them an attractive alternative to physical gold or ETF’s. Using futures and options is the most efficient way to take a bullish view on gold in the short term.

So what is the trade? We want a trade that offers us a good risk vs. reward ratio with a well-defined maximum loss and gain. This is what options can do for us.

Trade: Buying the GC Apr 1700-1730 Call Spread for $7.00

Risk: $700 per 1 lot

Reward: $2,300 per 1 lot

Breakeven: $1,707

A trade like this gives a trader a set up for more than 3-1 on their money if gold closes above $1,730/oz by April expiration. This also sets up for profitability at much more conservative levels than the Goldman $1,825 target.

About the Author

James Ramelli is the Moderator of the Live Futures Options Trading Room at KeeneOnTheMarket.com where he actively trades futures and options on futures while educating members on strategies, setups and risk management. He has a degree in Finance with a focus in Derivatives Trading and Financial Engineering from The University of Illinois and has been trading for five years. James appears regularly on Bloomberg T.V. and BNN and writes a weekly column for Futures Magazine.